How Labour Codes Repriced Employee Benefits on the BS ?

What Happened?

The Institute of Chartered Accountants of India (ICAI) has issued accounting clarifications stating that any incremental gratuity and leave encashment liability arising from the new labour codes must be recognised immediately as an expense.

Key clarification:

• The impact must be recorded in interim financial statements for the December quarter.
• The increase in liability qualifies as past service cost, not a prospective adjustment.
• This applies even though supporting labour code rules are yet to be notified.

In simple terms:
Once the law is effective, the accounting impact cannot be deferred.

What Changed Under the New Labour Codes?

The labour codes consolidated 29 labour laws into four unified codes, fundamentally altering how employee benefits are computed.

Key changes impacting gratuity:

• Redefinition of “wages”
  • Wages must be at least 50% of total remuneration.
  • Includes:
    • Basic Pay
    • Dearness Allowance
    • Retaining Allowance
• Expanded eligibility
  • Fixed-term and contractual employees eligible for gratuity after 1 year of service.
  • Five-year continuous service requirement continues only for permanent employees.

Earlier position:

• Gratuity payable only after five years of continuous service.
• Contractual and fixed-term employees were largely outside the scope.

Result:

• Larger covered employee base
• Higher wage base for computation
• Immediate increase in actuarial obligation

Numerical Break-up of the Impact

While company-specific numbers will vary, the impact typically arises from:

• Increase in Defined Benefit Obligation (DBO)
• Re-measurement of employee service cost
• Inclusion of employees previously excluded

Factors driving quantum:

• Size of workforce
• Proportion of fixed-term and contractual staff
• Wage structure (basic vs allowances)
• Average tenure profile

Importantly:

• This is not linked to new hiring
• It is a re-measurement of existing service obligations

Accounting Treatment — The Core Technicality

The accounting treatment depends on the applicable framework:

Ind AS Entities (Ind AS 19 – Employee Benefits)

Under Ind AS 19:

• Any increase in gratuity liability due to plan amendments or legal changes is treated as past service cost
• Past service cost must be:
  • Recognised immediately in the Profit & Loss Statement
  • Not deferred or amortised

Accounting entries typically result in:

• Debit: Employee Benefit Expense (P&L)
• Credit: Provision for Gratuity / Employee Benefit Liability

This directly impacts:

• EBITDA
• Profit After Tax
• Retained Earnings
• Net Worth

Non–Ind AS Entities (AS 15)

Under AS 15:

• Vested benefits: Immediate recognition
• Unvested benefits: Amortisation permitted

However, most listed companies, banks, NBFCs, and large entities fall under Ind AS.

Leave Encashment: Often Overlooked but Included

ICAI has also clarified that:

• Any additional liability arising from leave encashment changes under the new labour codes must also be recognised immediately.

This further adds to:

• Employee benefit expense
• Short-term earnings volatility

Balance Sheet vs Cash Flow Reality

Critical distinction:

• Accounting liability increases immediately
• Cash outflow occurs over time, when gratuity is actually paid

This means:

• Operating cash flows remain unchanged
• The hit is purely accrual-based
• No immediate liquidity stress

Hence, this is an earnings presentation issue, not a solvency issue.

Market Reaction and Earnings Interpretation

So far:

• No sharp market reaction
• Analysts are treating this as:
  • A one-time adjustment
  • A non-recurring accounting alignment

Likely market behaviour:

• Short-term PAT compression in December and March quarters
• Normalised run-rate earnings thereafter
• Focus shifting to adjusted earnings metrics

Underlying Financial Trend

This clarification reflects a broader shift:

• Moving employee benefits from “future obligations” to present balance-sheet commitments
• Reducing flexibility in wage structuring
• Aligning Indian reporting with global benefit recognition norms

Labour cost transparency is increasing, not labour cost itself.

Why This Matters — Governance and Financial Health

From a governance standpoint:

• Forces recognition of true employee obligations
• Improves inter-company comparability
• Prevents deferral of long-term liabilities
• Strengthens credibility of financial statements

For investors and lenders:

• Better visibility into workforce-linked risks
• Clearer understanding of sustainable profitability

Bottom-Line Verdict

This is not a new cost.
It is the accounting recognition of an existing obligation.

The labour codes did not weaken corporate balance sheets.
They removed timing discretion from accounting.

Professionals should read this as:

• Higher disclosure quality
• Temporary earnings impact
• Improved long-term financial transparency

This is accounting discipline — not financial distress.